Archives For risk

An ongoing tension in the debate around risk reporting is the gap between what investors want from a risk report and what companies feel is appropriate to disclose. The arguments are familiar: investors want a full and frank discussion of the risks the company faces; however companies say that providing any more detail than they currently do would require them to disclose commercially sensitive information.

In the first of a series of blogs on risk reporting, Jane Fuller, journalist and financial analyst, says this is a poor excuse for not being completely transparent.

I think it’s used too much as an excuse and it tends to infantilise the role of investors. Companies are effectively saying that they don’t want to frighten the horses.

I have been closely involved in responding to the initiatives developed by the IASB (the International Accounting Standards Board), the UK’s Financial Reporting Council and others since the financial crisis, which have collectively attempted to improve the risk reporting of financial institutions.

I feel that risk reporting in general still has some way to go, although guidance such as that from the Enhanced Disclosure Task Force of the Financial Stability Board has helped. The momentum towards better risk reporting has increased since 2008 – I have had more discussions about how to improve risk reporting since then. Moving things forward with purpose will require a change in attitude.

One of my major concerns about current risk reporting, and one that has been identified by CFA UK, is that risk reports rarely get to the fundamentals of what an identified risk would mean in practice i.e. the oil spill from BP’s Deepwater Horizon rig in the Gulf of Mexico in 2010. The group’s risk reports before the accident might have mentioned safety risks repeatedly, but there would have been little to help analysts in terms of what a rare accident might mean when looking at the financial impact it has.

BP could have said, for example, that accidents rarely happen but if one does, it will be very expensive for us and this is how we would mitigate the impact. Or a pharmaceutical company could disclose its general risk of litigation and say that while it happens on rare occasions, if it does happen the risk is considerable, perhaps illustrating this by disclosing the biggest payouts in the sector in the past.

This approach might cause migraines in many a boardroom but it would result in a far more useful discussion about risk. The main barrier to better risk reporting is companies’ reluctance to be frank. At the moment risk reporting is a process-driven exercise, which describes what they have looked at and the risk-management process, and that is a long way from a truly frank discussion.

The second problem is that risk reports have a management bias – a bias towards putting a gloss on everything. There is not enough challenging going on, from boards or auditors or investors, about the ‘what ifs’ – what if this went wrong? The reaction of some companies seems to be “don’t worry your little head about it.”

Ideally I would like to see risk reports that prioritise the major risks faced by the company, as well as identifying any emerging risks. A few banks, notably Barclays and HSBC, have experimented with this approach since the financial crisis and the results have been interesting.

This suggests that there is some scope for shortening risk reporting in the voluminous discussions and boilerplate lists sometimes produced. Some investors like the very detailed risk reporting you get in a prospectus. I’ve seen risk reports that run to pages and pages, Personally, I would like to see see risks prioritised, without losing too much detail. I would rather have 20 pages of risk disclosures and use my own brain than very few. If there is too much narrowing down of the reported risks it is more likely that something will be left out.

I don’t favour frequent or real-time risk reporting. It has to be a stand-back exercise and for that reason, I am generally happy with annual reporting. A focused, standalone interim report, which states the top risks and how the company is handling them, as well as any new risks that have emerged, might be a good addition, but risk reporting twice a year is enough.

The various initiatives designed to improve risk-based disclosures – such as the IAASB’s proposals on material misstatement – have had some impact. But even if the quality of risk reports improves, any sensible investor would see the report as just one element in making a decision. A risk report is the management’s perspective, after all. To get the full picture you need to look more broadly than that. You ask yourself if there is other evidence that you can collect that would shed more light.

It’s a timely reminder that to see the best view, you need to stand back.

This may sound like a lot but actually the figures should be much higher. SMPs need to look after ambitious SMEs and help them to grow into bigger business – it’s in the interest of both the accountancy firm and its clients. SMEs with international aspirations tend to deliver better performance and higher growth rates and hence make lucrative and prestigious clients for SMPs. Sooner or later, especially as they create deeper ties with their new markets, these international SME will build up substantial exposures to foreign currencies that could threaten the business’ profitability.

We know this from earlier research Kantox carried out with ACCA – internationalised SMEs and mid-market companies are typically exposed at a level of around 19% of revenue – of which possibly less than half is hedged in any way and even less is managed in an active manner. Frustrated by complexity and cost, and with only limited resources and access to relevant skills, some SMEs may be resorting to overly expensive hedging methods or taking their chances with the markets.

Even domestically-focused SMEs are not immune to foreign exchange risks. In regions heavily exposed to foreign banking sectors, like South East Asia in the 1990s and much of Central and Eastern Europe pre-crisis, businesses have been known to borrow in foreign currencies, thus taking on risks they were often ill-prepared for. Having access to good advice can, for such firms, be a matter of not just profit and loss, but life and death.

Yet ACCA and Kantox’s careful review of the Edinburgh Group data shows that SMPs aren’t always up to speed when it comes to SME clients’ exposures. Less than a quarter of SMPs with clients exposed to FX risk are involved in managing this. As a rule, in countries where volatile exchange rates make frequent headlines, practitioners are more alert to the potential problems than their clients; the opposite tends to be true in countries where SMEs deal in stronger currencies.

Resource is of course an issue for SMPs that do not have access to extensive professional networks or overseas partners, and thus have to solely rely on in-house staff to help internationalised small businesses. Anyone can buy and sell currency, but managing FX risk is a specialist skillset and not all practices can justify the up-front investment it requires. Typically, SMPs get drawn into FX risk management by one or two critically exposed clients, or when a critical mass of clients turns out to have exposures in need of monitoring. The more proactive ones make a point of building their brand around advising international businesses, and realise that FX is a natural part of the portfolio of such an adviser.

While FX hedging will always be highly dependent on context, including both company-specific factors and market dynamics, six simple rules can help business owners, and the practitioners who advise them, to approach the task correctly.

Define an FX hedging policy that is based on your risk appetite. If you want to hedge successfully, everyone in your company – board of directors, CEO, CFO, treasurer(s), accountant(s), etc – needs to know and share common targets and rules. Personally check that each board member has clearly understood the potential risks of the hedging policy previously defined. In some cases, board members prefer not to hedge the FX exposure to minimise costs and benefit from potentially favourable currency movements. Calculate worst case scenarios and present the results to them.

Identify your FX position and decide, on the basis of the hedging policy previously defined, whether they have to be hedged. It may seem obvious but to hedge successfully you need to know, at every moment, your exact FX exposure and its potential impact on your company’s profitability and competitiveness.

Don’t try to forecast currency movements or, at least, do not base your hedging decisions on currency movement forecasts alone. Do not forget that no one, including leading banks, is able to predict currency movements consistently, let alone forecast potential high-impact disasters on FX markets (think of Bear Stearns, Lehman Brothers, loss of the US AAA credit rating, Greece’s sovereign debt crisis).

Never speculate with your corporate cashflows. Do not forget that hedging FX exposure is not the core business of your company. This means that in managing corporate FX risk you should aim to make neither profit nor loss but rather maintain a zero balance. Do not forget that not hedging FX risk is similar to speculating.

Buy only what you understand. Make sure you fully understand the financial products you use to hedge corporate FX risk (forward contracts, futures, options, exotics, etc). Buying derivatives is quite easy but understanding how they are built and the hidden related costs and risks is much more complex.

Avoid ad hoc data manipulations. It is so easy to add or forget a ‘0’ when filling in data into a spreadsheet. Implement a treasury-management system. It may seem expensive, but only until your first big data mistake.

In a recent global survey of finance leaders by the ACCA and IMA (Institute of Management Accountants), there was one stand-out data point of significant interest on the priorities of CFOs. The data suggests an entire balance of different priorities, some of which are entirely consistent with the finance leaders growing mandate, particularly around business insight and risk, while others were more akin to their traditional finance responsibilities; cost management, control and working capital. This isn’t entirely a surprise and is consistent with soundings we get elsewhere across different markets. This is also a probable underlying story of re-adjustment post-crisis.

Pre-crisis, many CFOs were in deal-making mode and, over the last five years, merger and acquisition activity has generally been one-way traffic; it’s only now that we’re starting to see a potential surge. Pre-crisis too there was much talk of the role of finance as a business partner. The partnering agenda and drive for insight hasn’t gone away but there’s a sense post-crisis that most finance departments earn their spurs first and foremost on ensuring the business is effectively controlled, that it meets its regulatory requirements and that it protects and maximises the funds it creates. The crisis brought into focus sharply a refocus on the finance fundamentals, the importance of sufficient liquidity and strong financial control. Part of the rationale here also relates to the broader call out now for business practices that drive long-term sustainable performance.

To this end, CFOs have a tough job on their hands, balancing the need to develop financial strategies that are beneficial over the longer term, knowing most eyes continue to be on quarter-by-quarter results… and that’s no easy call for today’s finance leader.

Holger Lindner, member of advisory council, Singapore CFO Institute; former chief financial officer, Daimler South East Asia Pte Ltd., talks about the external factors and trends that shape the role of the CFO now and in the future. Holger discusses the areas of economic volatility and competition; greater risks rebalancing global economy with emerging markets in Asia, greater investor scrutiny, ethics and behaviour as key priorities for CFOs and finance leaders now.

The Changing Role of the CFO report explains how the financial and business landscape is changing: greater uncertainty for the global economy, fluctuating energy costs, rises in commodity prices, currency fluctuations, government deficits and cost cutting.

The DfT admitted that significant flaws had been discovered in the way the bidding process had been conducted. The risk assessment was messed up as a result of mistakes in the way inflation and passenger numbers were taken into account, and how much money bidders were then asked to guarantee as a result.

The track record on these processes is not good. The Transport Select Committee heard from Virgin boss, Richard Branson, at the beginning of September, weeks before the DfT ditched the franchise process. According to Branson’s evidence, on four recent occasions companies which won bids subsequently admitted to several financial difficulties or went bust.

You may think that the Department may be scarred by those experiences by now. We all need to be sceptical of forecasts that predict high growth right at the end of the period. And to be fair to the civil servants, that May 2011 guide is clear the biggest money bid won’t win unless everything else appears in order. The Department promises it will assess the cost and revenues set out in bids. If this assessment indicates a significant risk that costs of revenues will not be delivered or identifies other reasons why the franchise is likely to be financially unstable, the Department can rule out those bids from the competition on the grounds that they are financially high risk.

Aside from all the clever technical and academic input to investment appraisal, it boils down to one technical question: would I rather receive some money from that person now or much more in five years time? If you cannot see from a common-sense perspective where those big numbers are coming from, then perhaps it is time to say thanks, but no thanks.

The West Coast example should raise some awkward questions for how good accountants are at creating and understanding these models. They are in a good position to do the number crunching, but in building models what are their drivers? What pressures do they face in stressful commercial situations? They need to take a more independent, strategic position on the risk and reward that governments should ask for and private companies should be prepared to shoulder.

Maybe competent and honest professionalaccountantshavebecome too wedded to the all-pervadingefficacy of spreadsheets. As well as quantifiable risk which can be modelled, the accountancy profession needs to start looking at the impact of human psychology and behaviour in difficult and complex accounting and business contexts. We need to ask ourselves questions which we have barely started to think about: if we want to achieve a certain commercial result, how does that impact on the way we behave?